Understanding Taxes
Expert-defined terms from the Professional Certificate in Financial Literacy for Teens course at London School of Business and Administration. Free to read, free to share, paired with a globally recognised certification pathway.
Understanding Taxes #
Understanding Taxes
Taxes are mandatory financial charges imposed by governments on individuals and… #
Understanding taxes is essential for financial literacy as it helps individuals comprehend their tax obligations, make informed financial decisions, and avoid potential penalties. This glossary will cover key terms related to taxes, providing a comprehensive overview of the tax system.
1 #
Adjusted Gross Income (AGI)
Adjusted Gross Income (AGI) is a taxpayer's total income minus specific deductio… #
AGI is an important figure used to determine taxable income.
Example #
If Jane's total income is $50,000 and she deducts $5,000 in retirement contributions, her AGI is $45,000.
2 #
Deductions
Deductions are expenses that individuals can subtract from their taxable income… #
Common deductions include mortgage interest, charitable contributions, and medical expenses.
Example #
If Mark's taxable income is $60,000 and he has $10,000 in deductions, his taxable income will be reduced to $50,000.
3 #
Exemptions
Exemptions are a set amount of income that taxpayers can exclude from their taxa… #
Exemptions reduce the amount of income subject to taxes.
Example #
Sarah is eligible for a $4,000 exemption for herself and a $2,000 exemption for her dependent child, reducing her taxable income by $6,000.
4 #
Filing Status
Filing status determines the rate at which an individual's income is taxed #
Common filing statuses include Single, Married Filing Jointly, Married Filing Separately, Head of Household, and Qualifying Widow(er) with Dependent Child.
Example #
John and Mary can choose to file jointly as a married couple, which may result in lower taxes compared to filing separately.
5 #
Marginal Tax Rate
The marginal tax rate is the tax rate applied to the last dollar of income earne… #
It is the highest tax rate that an individual pays on their income.
Example #
If the marginal tax rate for income over $50,000 is 25%, Sarah will pay 25 cents on each additional dollar earned above $50,000.
6 #
Progressive Tax System
A progressive tax system is a tax structure where the tax rate increases as inco… #
Higher-income individuals pay a higher percentage of their income in taxes compared to lower-income individuals.
Example #
In a progressive tax system, individuals earning over $100,000 may be taxed at a higher rate than those earning $50,000.
7 #
Tax Credit
A tax credit is a dollar #
for-dollar reduction in the amount of tax owed. Tax credits are more valuable than deductions as they directly reduce the tax liability.
Example #
If James owes $1,000 in taxes and is eligible for a $500 tax credit, his tax liability will be reduced to $500.
8 #
Tax Deduction
A tax deduction reduces the amount of taxable income, which in turn lowers the a… #
Deductions can be either standard or itemized.
Example #
If Sarah has $10,000 in deductions and is in the 25% tax bracket, her taxable income will be reduced by $2,500.
9 #
Tax Liability
Tax liability is the total amount of tax owed to the government based on the ind… #
It is the final amount that must be paid to satisfy the tax obligation.
Example #
If Tom's tax liability is $5,000 and he has $2,000 in tax credits, he will owe $3,000 in taxes.
10 #
Taxable Income
Taxable income is the portion of an individual's income that is subject to taxat… #
It is the basis for calculating the amount of taxes owed.
Example #
If Mary earns $70,000 and has $10,000 in deductions, her taxable income will be $60,000.
11 #
Tax Withholding
Tax withholding is the amount of income tax taken out of an individual's paychec… #
It helps individuals meet their tax obligations throughout the year.
Example #
If Sam's employer withholds $200 from his biweekly paycheck for taxes, this amount will be applied towards his annual tax liability.
12. W #
4 Form
The W #
4 form is a document that employees fill out to indicate their withholding allowances, which determine the amount of federal income tax withheld from their paychecks. It helps employers calculate the appropriate amount of tax to withhold.
Example #
Jane completed her W-4 form with one withholding allowance, resulting in a higher amount of tax withheld from her paycheck.
13 #
IRS (Internal Revenue Service)
The Internal Revenue Service (IRS) is the federal agency responsible for adminis… #
The IRS collects taxes, processes tax returns, and issues refunds.
Example #
John received a notice from the IRS requesting additional information about his tax return.
14 #
Tax Bracket
A tax bracket is a range of income levels that are taxed at a specific rate #
Tax brackets are used to determine the amount of tax owed based on an individual's taxable income.
Example #
If Sarah's taxable income falls into the 22% tax bracket, she will owe 22 cents on each dollar earned within that range.
15 #
Tax Refund
A tax refund is the amount of money returned to an individual when their tax pay… #
It is typically issued by the government after the individual files their tax return.
Example #
If Michael's tax liability is $3,000 and he has $4,000 in tax payments, he will receive a $1,000 tax refund.
16 #
Tax Evasion
Tax evasion is the illegal act of not paying taxes owed to the government by und… #
It is a criminal offense punishable by fines and imprisonment.
Example #
Mark was convicted of tax evasion for hiding income from his business to avoid paying taxes.
17 #
Tax Avoidance
Tax avoidance is the legal practice of minimizing tax liability by using legitim… #
Unlike tax evasion, tax avoidance is within the bounds of the law.
Example #
Sarah engages in tax avoidance by maximizing her retirement contributions to reduce her taxable income.
18 #
Tax Planning
Tax planning involves analyzing financial situations to optimize tax efficiency… #
It includes strategies such as timing income and deductions, maximizing credits, and utilizing retirement accounts.
Example #
Tom consults with a tax professional to develop a tax planning strategy that reduces his overall tax burden.
19 #
Tax Audit
A tax audit is an examination of an individual's or business's financial records… #
Audits can result in adjustments to tax liabilities.
Example #
Mary's business was selected for a tax audit to ensure compliance with tax laws and regulations.
20 #
Tax Compliance
Tax compliance refers to the act of following tax laws and regulations by accura… #
Noncompliance can result in penalties and legal consequences.
Example #
John maintains tax compliance by keeping detailed records of income and expenses for his business.
21 #
Tax Fraud
Tax fraud is the intentional act of deceiving the government by falsifying tax r… #
It is a serious offense that can result in severe penalties.
Example #
Sarah was charged with tax fraud for fabricating business expenses to reduce her taxable income.
22 #
Tax Shelter
A tax shelter is a legal investment or financial strategy that reduces taxable i… #
Common tax shelters include retirement accounts, education savings plans, and certain types of investments.
Example #
Mark utilizes a 401(k) retirement account as a tax shelter to defer taxes on his contributions until retirement.
23 #
Payroll Taxes
Payroll taxes are taxes withheld from employees' paychecks by employers to fund… #
Both employees and employers contribute to payroll taxes.
Example #
If Jane earns $1,000 in wages, her employer may withhold a portion for payroll taxes before issuing her paycheck.
24 #
Filing Deadline
The filing deadline is the date by which individuals must submit their tax retur… #
For most taxpayers, the deadline is April 15th, unless extended by the IRS or falls on a weekend or holiday.
Example #
Mark filed his tax return before the April 15th deadline to avoid penalties for late filing.
25 #
Extension
An extension is a request to the IRS for additional time to file a tax return be… #
It grants individuals an extension of up to six months to complete and submit their tax returns.
Example #
Sarah filed for a tax extension to have until October 15th to complete her tax return.
26 #
Tax Preparer
A tax preparer is an individual or professional service that assists taxpayers i… #
Tax preparers have knowledge of tax laws and regulations to ensure accurate and timely filing.
Example #
Tom hired a tax preparer to help him navigate complex tax laws and maximize deductions on his tax return.
27 #
Tax Return
A tax return is a form filed with the IRS that reports income, deductions, credi… #
Individuals must file a tax return annually to determine their tax liability or refund.
Example #
Mary submitted her tax return to the IRS to report her income, deductions, and claim a tax refund.
28 #
Form 1040
Form 1040 is the standard tax form used by individuals to file their federal inc… #
It includes sections for reporting income, deductions, credits, and tax payments.
Example #
John completed Form 1040 to report his income, deductions, and calculate his tax liability for the year.
29 #
Tax Exemption
A tax exemption is an amount of income that is excluded from taxation, reducing… #
Exemptions are typically available for dependents, such as children or other qualifying relatives.
Example #
If Sarah claims an exemption for her dependent child, she can exclude a portion of her income from taxation.
30 #
Taxable Event
A taxable event is a transaction or activity that results in tax consequences fo… #
Examples of taxable events include selling property, earning interest income, and receiving dividends.
Example #
Mark's sale of stocks triggered a taxable event, requiring him to report the capital gains on his tax return.
31 #
Capital Gains
Capital gains are profits earned from the sale of assets such as stocks, bonds,… #
Capital gains are subject to taxation, with rates varying based on the holding period and type of asset.
Example #
Jane sold her investment property for a profit of $20,000, resulting in capital gains that must be reported on her tax return.
32 #
Capital Losses
Capital losses are losses incurred from the sale of assets that result in a decr… #
Capital losses can be used to offset capital gains and reduce taxable income.
Example #
If Tom experiences a capital loss of $5,000 from selling stocks, he can deduct this loss from his capital gains to reduce his tax liability.
33 #
Estate Tax
Estate tax is a tax imposed on the transfer of assets upon the death of an indiv… #
It applies to the total value of the deceased person's estate and is paid by the estate itself before assets are distributed to heirs.
Example #
Sarah's estate is subject to estate tax upon her passing, based on the total value of her assets at the time of death.
34 #
Inheritance Tax
Inheritance tax is a tax levied on the assets received by heirs from the estate… #
The tax rate and exemption threshold vary by state and may depend on the relationship between the deceased and the heir.
Example #
Mark inherited $1 million from his uncle's estate and is responsible for paying inheritance tax on the amount received.
35 #
Gift Tax
Gift tax is a tax imposed on the transfer of money or property from one individu… #
The donor is responsible for paying the gift tax, which may have exclusions and exemptions.
Example #
Jane gave her daughter a gift of $50,000, which exceeds the annual gift tax exclusion, resulting in a gift tax liability.
36 #
Property Tax
Property tax is a tax imposed on the assessed value of real estate or personal p… #
Property tax revenues are used to fund local government services and schools.
Example #
Tom's annual property tax bill is calculated based on the assessed value of his home and the local property tax rate.
37 #
Sales Tax
Sales tax is a consumption tax imposed on the sale of goods and services at the… #
The tax rate varies by state and may be applied to specific items or categories of products.
Example #
Sarah paid a 7% sales tax on her purchase of a new laptop at the electronics store.
38 #
Excise Tax
Excise tax is a tax imposed on specific goods or activities, such as alcohol, to… #
Excise taxes are often included in the price of the product and paid by manufacturers or consumers.
Example #
Mark paid an excise tax on his purchase of cigarettes, which is included in the retail price of the product.
39 #
Sin Tax
Sin tax is a type of excise tax levied on products or activities considered harm… #
Sin taxes aim to discourage consumption and generate revenue for public health programs.
Example #
Jane paid a sin tax on her purchase of a bottle of wine, with the proceeds used to fund addiction treatment programs.
40. Value #
Added Tax (VAT)
Value #
Added Tax (VAT) is a consumption tax levied on the value added at each stage of the production and distribution process. VAT is typically included in the price of goods and services and paid by consumers.
Example #
Tom's purchase of a new car includes a 10% value-added tax, which is calculated based on the incremental value added by each stage of production.
41 #
Tax Code
The tax code is a set of laws and regulations that govern the administration of… #
The tax code specifies tax rates, deductions, exemptions, and credits that apply to individuals and businesses.
Example #
Sarah consulted the tax code to determine the eligibility criteria for claiming a specific tax credit on her return.
42 #
Taxpayer
A taxpayer is an individual or entity that is subject to paying taxes on income,… #
Taxpayers are responsible for accurately reporting income and complying with tax laws.
Example #
John is a taxpayer who files an annual tax return with the IRS to report his income and deductions.
43 #
Withholding
Withholding refers to the amount of money deducted from an individual's paycheck… #
Withholding ensures that taxes are paid throughout the year.
Example #
Mary's employer withholds a percentage of her wages for federal and state income taxes before issuing her paycheck.
44. Form W #
2
Form W #
2 is a tax form provided by employers to employees that reports their annual wages, tips, and other compensation, as well as taxes withheld from their paychecks. Employees use Form W-2 to file their tax returns.
Example #
Jane received her Form W-2 from her employer, which she will use to report her income on her tax return.
45 #
Form 1099
Form 1099 is a series of tax forms used to report various types of income receiv… #
Recipients use Form 1099 to report income on their tax returns.
Example #
Mark received a Form 1099-INT from his bank, reporting the interest income earned on his savings account.
46 #
Tax Audit Red Flags
Tax audit red flags are indicators that may trigger an IRS audit of an individua… #
Common red flags include high income, large deductions, inconsistent reporting, and failure to report income.
Example #
Sarah's failure to report income from freelance work on her tax return raised red flags and led to an IRS audit